Muni bonds grow scarcer

Investors attracted by lower risk, last year's performance

RayMartin

SAN FRANCISCO (CBS.MW) -- Investors coming to the diversification altar are finding the pickings are slimmer than ever when it comes to municipal bonds.

I recently asked three different brokerage firms to fill orders for clients seeking high-quality, intermediate municipal bonds issued by their state. We're still looking.

There's a strong and accelerating demand for individual municipal bonds as individual investors and muni-bond funds snap them up as fast as the supply hits the market. One major reason for this is that the U.S. Treasury continues to pay down the federal debt by reducing the number and amount of Treasurys issued.

As a result of the shrinking supply of Treasurys and growing supply of cash to invest in bonds, some Treasurys have been bid up to yield less than tax-exempt municipals of the same maturity. This is unusual. Historically, the yield on 10-year municipal issues has averaged about 80 percent of the yield on 10-year Treasurys.

Also, state governments have held up issuing new bonds as they watch the FOMC rate cuts, waiting for the lowest rates to refinance their debt.

Finally, demand has grown as investors couldn't help but notice the performance of muni bonds last year, with the Lehman Muni Bond Index rising more than 11.7 percent while stocks suffered.

A marriage for munis

Municipal bonds or funds are a good alternative for the lower-risk portion of a portfolio for investors in the 31 percent federal tax bracket. You don't have to have a lot of income to be here: in 2000 this applied to married filers with taxable income of more than $150,950 ($63,550 for singles), 31 percent of every dollar of certain types of investment income will be owed in Federal taxes.

Investors couldn't help but notice the performance of muni bonds last year, with the Lehman Muni Bond Index rising more than 11.7 percent while stocks suffered.

Said another way, if your money market fund is earning 4 percent, you're actually only keeping about 2.76 percent after tax -- less if your federal tax bracket is higher and even less after you take into account state income taxes! That may not even be keeping up with the current level of inflation.

Interest paid on bonds issued by state agencies and governments is generally exempt from federal taxes. If issued by your state's government, it may also be exempt from your state's income tax. The U.S. Tax Code exempts this interest from federal taxation, allowing states to pay lower interest rates on their loans.

Municipals offer a relatively low-risk opportunity to diversify a portfolio. The default rate of general obligation bonds (GO) is less than one percent nationally. GO bonds come with the secure backing of the tax collections of the states that issue them. Another category, revenue bonds, is backed by the income from the projects -- such as tolls, bridges, etc. -- that they are issued to finance.

Finally, an additional layer of protection can come in the form of bond insurance that assures the timely payment of interest and principal to the investors who hold the bonds.

To buy or not to buy

Consider buying individual municipal bonds if you have more than $250,000 to allocate toward this investment category. The advantages are securing a steady stream of tax-free income without the cost of ongoing management fees.

Investors can buy shares in a muni bond fund with as little as $1,000.

Consider higher quality GO bonds or insured revenue bonds. These bonds will be rated AA or higher by the major rating agencies. You may want to avoid bonds backed by certain projects such as health-care or power projects as these industries are in flux and face significant challenges.

Seek bonds that mature in seven to ten years or less.

Try to buy at least 10 issues and spend at least $25,000 per issue. Avoid paying more than the bond's maturity value (called premium bonds) which is next to impossible now when shopping for existing bonds. If you do pay a premium, you'll get higher interest payments, which is in essence a return of some of your principal.

When assembling a portfolio of muni bonds, stagger them by maturity and coupon payment dates to diversify your reinvestment risk and provide a steady supply of income from the portfolio.

Finally, keep transaction costs down by shopping around at several brokerage firms. Brokers add their commission in the form of marking up the price of the bond, which increases your cost and reduces your yield. Ask the broker what the mark-up is and compare that to what others are offering.

Advantages of bond funds

Investors can buy shares in a muni bond fund with as little as $1,000. These funds are portfolios of bonds issued by a variety of states or concentrating only in a single state, to emphasize diversity and tax benefits.

While all are important, past performance and low expenses seem to be the most significant indicators affecting future performance. In a recent study of top quartile ranked bond funds from Morningstar's five bond fund categories for 1997 to 1999, 70 percent of the top performing funds in the five categories studied had both above average performance and below average expenses.

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